Selling a Restaurant Business - An Overview of Financial and Federal Tax Considerations
All of your blood, sweat, and tears have been poured into your restaurant, but the time has come - you’ve decided to divest ownership of your restaurant. When you’re preparing to sell a restaurant, there are a number of ways to make your business more appealing to potential buyers, ranging from cosmetic updates and repairs to improving the quality of the financial records you will provide to prospective buyers.
The scope of this article is to address financial and federal tax issues a restaurant seller should consider with the intent to better prepare the seller for a successful sales process.
GET FINANCIAL RECORDS READY
The more organized and complete financials you can provide, the more appealing you will be to quality buyers and more likely you will achieve a higher selling price. Financial records include the income statement, which is a record of income and expenses, and a balance sheet, which is a list of assets such as accounts receivable, inventory, equipment, furniture, real estate and leasehold improvements along with any accounts payable and debts on the business. These two reports are the most basic records a prospective buyer will request. Other more detailed information that is also often required will be discussed in further detail in the “Due Diligence” section of this article.
PROTECT CONFIDENTIAL INFORMATION
Before providing financial or other business information to anyone, you need to assess your need to protect your private and confidential information. Some restaurant sales could be adversely affected if “word got out” that the restaurant was “for sale.” Competitors could use the uncertainty of future ownership to steal your most valuable employees or deter customers from your restaurant. Potential buyers could intentionally or unintentionally obtain your business information during early sales discussions. For these reasons, sellers should consider utilizing nondisclosure agreements in the selling process.
The purpose of a nondisclosure agreement is to protect your confidential information as the misuse of such information could negatively affect your ability to obtain the best purchase price for your business. The agreement should be prepared by an attorney and will include, at minimum, provisions limiting what information the buyer can disclose about the seller, as well as what actions the buyer can or can’t engage in regarding the seller’s employees and customers. These agreements should be signed by both the buyer and seller before any sensitive or detailed information is provided to a potential buyer.
Due diligence is the process where a potential buyer is performing research and analysis of your business or organization in preparation for a business transaction. Due diligence is generally not performed until a potential buyer has made an offer in the form of a letter of intent (LOI) and the seller has accepted it. Although the typical LOI is nonbinding, it indicates both parties have agreed on significant terms (such as sales price) and both parties have serious intent prior to beginning the due diligence process.
Due diligence may be performed by the buyer themselves, or depending on the size or scope of the transaction, the buyer may engage a Certified Public Accounting firm or other third-party to perform the analysis. When performing due diligence, a buyer (or buyer’s representative) will usually submit a “Tax Diligence Request List” to the seller. While the items requested vary, the list typically includes items relating to financial records and tax information along with items relating to business operations, policies and procedures. The following list is a
sample of commonly requested information. Be prepared to provide at least three years of information for each item.
- Federal income tax returns;
- All federal tax elections;
- Description of certain tax accounting methods, accounting method change requests and tangible property capitalization policies;
- State income tax returns and state income tax apportionment schedules;
- Quarterly and annual payroll tax filings;
- Sales and use tax returns;
- Property tax returns;
- State escheat, unclaimed or abandoned property tax returns;
- All correspondence with the IRS or state/local taxing authorities including determination letters from federal, state or local audits;
- Legal or accounting tax opinions related to past 3 years tax returns;
- Policy regarding use of independent contractors and/or employee classification;
- List any pending or threatened disputes with regards to tax matters; and
- Description and detail of any related party transactions.
As mentioned in the “Financial Records” section earlier, you’ll want to attract quality buyers to obtain maximum selling price for your restaurant, and those buyers will require the detailed financial records listed above. If both parties are satisfied upon completion of due diligence, the next steps is executing a final purchase/sale agreement.
SEEK PROFESSIONAL ADVICE
Each business sale transaction is unique and the outcome depends on a myriad of factors, including the business entity type and ownership structure, as well as the seller’s short-term and long-term financial goals. Use of attorneys and tax accountants for independent advice on transactions can enhance the selling process as well as limit legal and tax liabilities. The following list is a sample of tax advisory matters where legal and tax professionals can add value to your transaction:
- Asset valuation and pro forma sales price analysis;
- Understanding your tax posture and how various sale structures will impact the after-tax sale proceeds;
- Tax deferral strategies (installment sales, “earn-outs” over multiple future years);
- Post sale retirement/financial planning, estate planning; and
- Post sale tax mitigation strategies (investment in syndicated offerings that include Federal and/or State tax credits or conservation easement deductions).
CALCULATE PROFIT AND TAXES
Profit, or taxable income, is the difference between your proceeds from the sale and your tax basis of relinquished assets. Generally, your proceeds from the sale are the total sales price, which can include cash, plus any other assets received, plus any liabilities the buyer assumes from you. Generally, your tax basis is your original cost for the assets, less depreciation deductions or casualty losses claimed, plus selling expenses.
The amount of tax you will owe depends on whether the taxable income generated from the sale is taxed as capital gains or taxed as ordinary income. Currently, the maximum ordinary income tax rate is 39.6 percent while the maximum capital gains tax rate is 20 percent. (Note that additional taxes may also apply, such as the Federal Net Investment Income tax of 3.8
percent, Federal Medicare Surtax of 0.9 percent and state income taxes. However, discussion of each of these taxes is outside the scope of this article.)
If the sale of a restaurant business is transacted as a sale of the business assets, it may require the buyer and seller to provide an allocation of the sales price among several classes of assets sold, based on each asset’s fair market value. Income tax will be calculated on the taxable income amount allocated to each class of asset. Sellers will want to maximize the amount of sales price allocated to capital assets sold because the corresponding gain will be taxed at the lower capital gains tax rates.
For example, the portion of the profit that is allocated to the sale of intangible business assets such as goodwill, going concern value, trademarks, trade names, licenses, permits and other intangible assets is usually taxed at capital gain rates. Conversely, the portion of profit that is allocated to inventory, accounts receivable, or other business property held less than one year will be taxed at ordinary income rates. If your sales contract includes an amount paid to the
seller/owner personally to provide consulting services, then the amount you will receive under that consulting agreement will be taxed as ordinary income.
By using your time and resources to obtain an understanding of your specific tax and legal implications entering into any transaction, you can not only avoid costly mistakes but also keep as much of your hard-earned sales proceeds as possible.
About the Authors
Timothy Watt is a CPA at Bennett Thrasher LLP, a comprehensive tax, accounting, assurance and consulting services firm in Atlanta, Georgia. Watt is a partner in the firm’s Tax department, as well as a member of the Real Estate practice. He may be reached at firstname.lastname@example.org or (770) 396-2200.